The one cardinal rule in retail is that everything you buy, you have to sell. When shoppers are crowding through the doors and merchandise is filling up shopping carts, this simple rule isn't a problem. But when times get tight, retailers lose sight of this "religious" principle and get caught in a catch-22.

How do you drive sales when you're stuck with merchandise that hasn't sold? Usually, buying more stuff only adds to the problem. Accordingly, managing your inventory like a hawk is the only real solution.

Retailers with inventory religion
Keeping inventories lean produces a flood of benefits for retail companies. It's not just avoiding the dreaded markdowns, although they can be painful. It also frees up space to buy the next hot item, cuts store labor costs because you don't have to keep moving the merchandise around, and keeps the supply chain from getting hopelessly clogged -- truly a virtuous cycle that can be self-perpetuating.

We're only about halfway through the holiday retail reporting calendar, but it's already becoming clear which retailers have found this religion and which haven't. I like to compare sales growth with inventory growth and measure the gap in percentage points:

Q4 Sales Growth



Inventory Gap

Wal-Mart (NYSE: WMT)




Target (NYSE: TGT)




Macy's (NYSE: M)




J.C. Penney (NYSE: JCP)




Home Depot (NYSE: HD)*




Lowe's (NYSE: LOW)




Source: Company quarterly earnings releases.
*Home Depot sales growth adjusted down 6.4% for an extra week in the fourth quarter.

Wal-Mart shows Target the door
Fellow Fool Alyce Lomax recently noted that Wal-Mart is in its element. While she was referring to price leadership, the company has also learned that less can be more when it comes to inventory management. The company ended January with inventory up only 4.4% on sales growth of 8.3% -- a favorable gap of 3.9 percentage points. Target is headed the opposite direction, however, with a gap of negative 7.6. While I grant that the smiley face has the benefit of a larger mix of food, which turns over rapidly, you can bet that Wal-Mart will have more space available to feature spring merchandise in the next few months.

Department store vigilance
During the holidays, I noted that everything was on sale at J.C. Penney. Sure enough, when the dust settled, margins took a nosedive. Now the company is taking a vigilant approach to planning in 2008.

Inventory management is even more important for department stores, because fashion apparel doesn't have anywhere near the useful shelf life of consumer staple items. Macy's is clearly in a far more favorable inventory position going into the next season. Most apparel retailers haven't reported holiday results yet, but it will be instructive to see which companies have kept their inventories on the lean side.

Home improvement woes
I've given Lowe's a slight nod over Home Depot in the past on what looks like more savvy merchandising, but this quarter I'm having a change of heart. Both companies are struggling big time with the housing downturn, and investors are wondering where the bottom is.

When times are bad, inventory management takes center stage because there are fewer shoppers to help move the goods. I'm impressed with Home Depot's tight inventory management this quarter -- down 8.5% versus last year. While a portion of Lowe's surprising inventory increase is because of a higher ratio of new store openings, it looks to me like Home Depot is more on top of its merchandise.

I don't see any clear signs yet that consumers are opening up their wallets. As long as the economy remains in the doldrums, I'm betting that retailers with "inventory religion" are in the best position to benefit.

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Fool contributor Timothy M. Otte surveys the retail scene from Dallas. He welcomes comments on his articles, and owns shares of Wal-Mart, but none of the other companies mentioned in this article. Wal-Mart and Home Depot are Motley Fool Inside Value selections. The Fool has a disclosure policy.